The Fed Gets Ready to Backpedal

March 19, 2002

By Michael Wallace After 15 months, one recession, and one budding economic recovery, the Federal Reserve has announced it is changing its policy stance on short-term interest rates. Following an unprecedented easing of a full four percentage points since the start of 2001, Greenspan & Co. shifted to a neutral bias at the Mar. 19 meeting of the Federal Open Market Committee (FOMC), the Fed's policymaking arm. The Fed's new policy outlook sees the risks to the economy roughly balanced between slower growth and higher inflation -- a move away from the easing stance that had been in place since December, 2000.

The Fed formally adopted this stance in light of "the economy expanding at a significant pace." But in its characteristically cautious fashion, the central bank also expressed some lingering reservations about the strength of final demand.

In an expanded five-part statement, the Fed paved the way for less accommodative monetary policy going forward. (For more on the nature of the FOMC's announcements, see BW Online, 3/19/02, "Don't Misread the Fed's "Bias" Statement".) The announcement issued at the end of the meeting dropped what had become a familiar refrain: "The risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future." Now, while acknowledging that monetary policy "is currently accommodative," it stated that "against the background of its long-run goals of price stability and sustainable economic growth and the information currently available, risks are balanced with respect to both goals."

WIGGLE ROOM. The neutral stance may prove short-lived, however. A sharp inventory-led correction may generate first-quarter gross domestic product growth in excess of 5%, which would make a lengthy stay at neutral increasingly difficult to maintain. This raises the odds of a move to a tightening bias as soon as the May 7 FOMC meeting, or certainly by its two-day gathering on June 25-26, assuming the Fed is aiming for a smooth transition to an August rate hike, as we at Standard & Poor's MMS expect.

The market seems to agree. Fed funds futures, a vehicle for market pros to place bets on future moves in interest rates, traded lower ahead of the announcement, but snapped back afterwards. The May contract has priced in about a 54% chance of a quarter-point tightening that month. The June contract now signals about an 80% chance. And the July contract continues to fully price in a tightening and shows about a 68% risk of an additional quarter point hike that month.

Greenspan & Co. did not back itself into a corner by narrowing down the timing of any reversal to a tightening mode -- or by leaping ahead to a tightening bias. This also served another, unstated purpose: reining in long-term interest rates to give the nascent recovery, however unexpectedly strong it might appear right now, some breathing room. Therefore, bond prices may stabilize, keeping rates on an even keel, until investors have a clearer sense of the timing of any Fed-driven rate hikes.

NEW WRINKLE. The FOMC's announcement achieved maximum policy flexibility while maintaining a heightened sense of alert to the possibility of an overheating economy. Clearly, the Fed remains prepared to adapt to a fast-moving environment.

One new wrinkle was the announcement that at future meetings, the FOMC will release its roll call of the vote on the policy target -- and the preferred policy choice of any dissenting voters -- immediately, rather than six weeks later when it releases the minutes of the meeting. This move accelerates policy transparency and should be welcomed by the markets. The Board of Governors will also report in the written announcement the roll call of any vote on the discount rate, including the preference of dissenters. There were no dissenters this time around, according to the statement.

The shift to a neutral policy bias was met with relief in the markets, which had already priced in such a change prior to the widely anticipated Mar. 19 meeting. However, Chairman Alan Greenspan's recent equivocation in testimony on Capitol Hill over the timing and health of the expansion had made that shift more uncertain than it otherwise would have been.

Though the fixed-income markets were modestly higher in light trading ahead of the Fed's announcement, an initial post-meeting bond rally stalled out, and Treasury prices finished only slightly higher. Stocks initially tumbled, but investors recovered their composure, leaving equities with small gains for the day. The dollar, which strengthened at first, retreated by day's end. Wallace is chief market strategist for S&P/MMS International